Seldom has fixed-income, currencies and commodities trading (known as FICC) been under such pressure at big US banks. Perhaps not since the 2008 financial crisis.
A combination of tough markets and structural challenges – from new regulations to the shift towards more transparent electronic trading – are taking their toll on FICC divisions, which a decade ago were core drivers of big US investment banks’ profits.
Consider the top US banks’ 2016 first-quarter results. Profits at all of the big banks – JPMorgan Chase, Bank of America Merrill Lynch (BAML), Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley – fell, and in some instances dramatically. Five of the six banks also reported shrinking revenue, prompting some analysts to question what the banks plan to do in future, and whether they can generate the level of business they have previously (see chart).
A story of two halves
The first-quarter results tell two different stories.
Goldman Sachs and Morgan Stanley – banks focused almost entirely on trading in capital markets and investment banking – suffered the most. Goldman Sachs' first-quarter profits dropped 56% to $1.2bn from a year earlier and its revenue shrunk 40% to $6.3bn, its worst first-quarter result in 12 years. Morgan Stanley, the smallest of the Wall Street banks, fared only slightly better. It recorded a 53% decline in profits to $1.1bn and a 21% decline in revenue to $7.79bn, compared with the year previous.
JPMorgan, BAML, Wells Fargo and Citigroup were able to offset steep declines in revenues from their Wall Street banking operations with growth in their vanilla banking businesses, notably in consumer lending, where mortgages, credit card loans and auto loans all increased. This exemplifies the advantages of diversified bank strategies. It also suggests that the US economy is strong, at least as far as consumer demand is concerned. US companies also continued to borrow from banks as they have done in the past several years, taking advantage of low interest rates.
The only large US bank that recorded revenue growth in the first quarter of 2016 – by 4.3% to $22.2bn – is Wells Fargo, the US’s third largest bank, which has a very small bond and stock trading division compared with the country's other big banks. Indeed, Wells Fargo is best known as the country’s leading mortgage lender, and loans at the lender were up 10% to $947bn in the first quarter.
Commercial banking loans grew 13% at both JPMorgan and BAML.
There was, however, a common feature in all the big banks’ first-quarter results: each of the big investment banks, but especially Goldman Sachs and Morgan Stanley, cut costs to help compensate for declining profits. Goldman Sachs cut total expenses by 29% to $4.7bn, largely by slashing employee compensation and benefits by 40%.
A bad start
At the heart of the first-quarter declines in profit and revenues at the US’s five big Wall Street banks – JPMorgan, BAML, Citigroup, Goldman and Morgan Stanley – is a dramatic drop in sales and trading revenue from FICC markets, as well as a fall in revenue from investment banking divisions.
Revenue from FICC trading fell by 56% at Morgan Stanley – the weakest performance among the big banks – and a 16% decline was felt in its investment banking business, which covers income from fees advising companies on mergers and acquisitions (M&A) and underwriting companies’ bond and share offerings.
At Goldman Sachs, revenue fell 23% in investment banking and 47% in FICC trading. Indeed, FICC trading revenue accounted for just 26% of Goldman’s total revenue – a far cry from the 40% the business regularly contributed before the financial crisis.
Goldman Sachs was also hit by a 95% decline in revenue – to $87m from nearly $1.7bn a year earlier – in an opaque $99bn portfolio of loans and securities that constitute the bank’s investing and lending activities. Commentators said the size of the decline reinforced shareholder concerns about the big swings and lack of transparency in this part of Goldman Sachs' business.
Pain at the other big trading banks was also significant. BAML saw revenue decline by 22% in investment banking and by 16% in its sales and trading unit. Investment banking fees at JPMorgan were down 24%, while trading slumped by 11%. Citigroup saw decreases of 27% and 13%, respectively.
The results are particularly concerning as usually the first quarter is the most active time for banks’ trading and sales desks, as corporate clients plan how to meet their year’s financing needs and large investors adjust their portfolios.
Blame game
The culprits of the downturn are well known: there is uncertainty over global growth, China’s economic downturn, the low price of oil and the impact of all these factors on emerging market economies and energy and energy-related industries.
On top of that, at their first annual policy meeting on March 15 and 16, 2016, US Federal Reserve officials left short-term interest rates unchanged and sharply reduced their projected path of interest rate rises this year, down from the percentage point increase that was slated in December 2015 – when the US central bank raised US interest rates for the first time in seven years – to a half percentage point increase.
Janet Yellen, the chair of the Fed, explained at an Economic Club of New York event on March 29, 2016, that global economic and financial uncertainty pose risks for the US economy, justifying a slower path of interest rate increases.
Low US interest rates, combined with negative rates set by central banks around the world, hurt US banks with big lending businesses by decreasing lending margins. But low rates have also kept fixed-income or bond trading volumes very low, damaging trading revenues.
Trading volumes stayed sluggish during a bout of extreme volatility at the start of the year, which pushed investors to the sidelines. “I’ve heard several people explain that in this case much of the volatility, rather than encouraging more trading, led investors to worry and caused them to pull back from the markets,” says Kevin McPartland, head of structure and technology at US advisory firm Greenwich Associates.
Simultaneously, on the sell-side, leading US banks have become much less willing to underwrite bonds issued by companies with low credit ratings, high debt or which have been hit by low oil prices. US M&A fell 21% to $229bn in the first quarter of 2016, compared with the same quarter a year previous. New bond issuances and sales in the riskiest part of the corporate debt market – the US junk bond market – dropped 70%, according to data from financial markets platform Dealogic.
Going into the second quarter, confidence returned to US stock markets and bond issues in the lower yield, investment-grade corporate bond market rose. This led to optimism among some bank executives that deals that were put on hold earlier this year could resurface, and FICC trading might recover. But, most agree, it is too soon to say whether the recent buoyancy in markets will continue.
The tough market conditions at the start of the year follow years of anaemic bond market activity and revenues weighing on bank earnings. This has led analysts, commentators and eventually US bankers to accept that the decline in trading revenues in FICC is not merely cyclical – a reflection of the Fed’s ‘lower for longer’ policy, for instance – but that the business is in secular decline.
This might explain Morgan Stanley’s recent decision to cut the number of its bond traders by 25% and sell its physical commodities business.
Regulatory squeeze
Commentators, analysts and bankers widely agree that structural changes are a fundamental reason why FICC trading may never be as profitable as it once was. Higher capital requirements and tougher regulation since the 2008 financial crisis – coupled with moves to more transparent but lower earning electronic trading – are hitting FICC profitability on several fronts.
The biggest issue, arising from the US Dodd-Frank Act and Basel III, is the increased cost of balance sheet usage due to higher capital requirements and new capital rules. The new rules, according to regulators, are meant to align banks’ capital buffers more closely with the riskiness of FICC instruments – not least because poor bank management of ultra-risky mortgage-backed securities and complex derivatives helped precipitate and magnify the 2008 economic meltdown.
As a consequence of the new rules, FICC dealers at banks have cut back on the amount of capital allocated to the business. Most conspicuously, dealers have reduced the amount of inventory they carry because it has become much more expensive to maintain. At the same time, in their market-making capacity, bank dealers have also become increasingly selective about when and to whom they will allocate capital or liquidity to support and complete trades.
The extent to which banks’ FICC business is diminishing is illustrated by Morgan Stanley’s reduction of its FICC risk-weighted assets by almost two-thirds, from $370bn in the third quarter of 2011 to $136bn at the end of 2015, Edward Pick, the bank’s newly appointed head of trading said at a recent financial conference.
The tech effect
Following a shift towards electronic trading in bond markets, all the big US banks have invested in electronic trading platforms capable of executing trades across groups of assets. Some of the new platforms also have algorithmic trading functions, pre-trade research, analysis and structuring tools, and post-trade clearing, settlement and reporting capabilities.
Hung Tran, executive managing director at global banking group Institute of International Finance, believes that, as a result of changes and shrinkage, the contribution of FICC trading in overall US investment banking profits will decline over the next three to five years. Simultaneously, the contribution of more stable, less risky and less capital-intensive revenue steams, such as advisory services for companies that want to raise funds or carry out a merger or acquisition, and equities trading, will grow to more than 50%. “That is a strategic path that many banks want to explore,” Mr Tran says.
Meanwhile, the degree to which electronic trading penetrates any given bond market depends largely on the uniformity of the product.
According to James DeMare, co-head of fixed-income trading at BAML, in the corporate debt markets the lack of homogeneity between companies and debt dissimilarities means that banks can play a significant role providing advice, and other skills and services, in bond deals, bond issues and related derivatives trades – for instance, to help a company hedge against currency and interest rate risks or changes in raw materials prices.
As this work is invariably privately negotiated and bespoke, the earnings can be very high and many times more than the comparatively low fees charged for automated bond trading.
Nevertheless, even in the less uniform corporate bond markets, there is no sign of a slowing momentum in standardising as many bonds as possible so that they can be openly and electronically traded. In the US corporate debt market, for less risky investment-grade companies where yields are low, the volume of automated trading has risen to 20%, according to US advisory firm Greenwich Associates. In the junk bond market for companies with low credit ratings but higher yields, it is 6%
A change of direction
Another area of FICC trading that is much more heavily regulated is derivatives. Raising costs and reducing risks, banks now have to hold much more capital against derivatives books. And instead of credit default swaps (CDS) being negotiated privately and away from transparent exchanges, they now have to be traded on open platforms and routed through clearing houses, which take fees to guarantee trades.
Moves are also under way to clear single-name CDS. These are swaps that are bespoke and designed to fit an individual company’s particular hedging needs. The increased attention comes as CDS are likely to become more useful to institutions as corporate defaults rise with gradually increasing US interest rates, and swaps are needed to provide protection against credit risks, for instance, in the corporate energy sector due to the low price of oil.
Most Wall Street banks are still actively engaged in the business of bilaterally negotiated, bespoke and often complex CDS. But Wells Fargo, which is the world’s most highly capitalised bank, is an exception. Though a small FICC trading player, Wells Fargo has seen the revenue of its fixed-income business grow in the past few years. For the past three years it has also “consistently had a leading market share” in the US electronic market for investment-grade corporate bonds, says Walter Dolhare, head of the markets division in Wells Fargo securities.
According to Mr Dolhare, Wells Fargo is a proponent of cleared CDS, including single-name CDS, and only engages in cleared swaps, “which is where regulators want to take this business”, he says.
“We are big proponents of that cleared product. For cleared single-name CDS I think it will take two to three years for a robust market to develop. But there is significant and growing support for it. I think it will happen.”
The upshot is that while the FICC revenues of the big Wall Street banks may be hurt over the next few years by a reduction in higher margin, privately negotiated, bespoke CDS, Wells Fargo will endure no such pain. Any increase in Wells Fargo’s trading in cleared CDS will be “an incremental gain” in its revenues, says Mr Dolhare.
As for proprietary trading – previously one of the most profitable and also one of the riskiest forms of trading at big US banks – according to the Volker Rule, named after former Federal Reserve chairman Paul Volker, banks are now banned from using their own money to make trades or bets on their own account, and are also restricted on how and when they can invest in hedge funds and private equity.
“There’s no question that implementation of the Volker Rule since July 2015 has had an impact,” says one US banker.
But not at Wells Fargo. “The Volker Rule didn’t hurt us at all other than the considerable expense and complexity of complying,” says Mr Dolhare. “But it didn’t cause any change in our business model. It didn’t change the revenue-line item, because we were never really involved in proprietary trading.”
Some light ahead
Against this background, while nobody believes FICC businesses will be nearly as lucrative as they were before the crisis, the outlook is by no means all gloomy. Mr Dolhare believes transformational change from a regulatory point of view is now nearing an end. “And when the cyclical issues subside, I think there will be significant opportunity. From this point, fixed-income revenue shouldn’t be that challenged,” he says.
BAML’s Mr DeMare thinks big US trading banks have advantages compared with their European peers. JPMorgan, BAML, Citigroup and Goldman Sachs are in the top five positions in terms of market shares in credit, currency, rates and commodities products, and other bond markets in the US, as well as regionally and globally. They are also diversified both in products and geographically. And because of the US Dodd-Frank Act in 2010, US banks moved more quickly than their European competitors in raising equity, shoring up balance sheets and meeting Basel III capital requirements.
As a result, in spite of the tough markets none of the big US banks have had to withdraw from entire businesses as many European banks have, such as Credit Suisse, UBS, Deutsche Bank and Royal Bank of Scotland. That will put the big US banks in a strong position when market conditions improve and the trading and business cycle turns.
Mr DeMare says: “Whether talking to me or to someone at JPMorgan or Goldman Sachs or Citi, our motto is simple: we can gain market share even in a declining revenue market.”
That may well be. But though big US banks have survived, it is not clear if all of them will be able to excel. Pressures on FICC trading to be less risky, less capital intensive, more transparent and involve more technology will no doubt continue, affecting profitability.
